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CHAPTER 3: 

CHAPTER 3 How Securities are Traded

How Firms Issue Securities: 

How Firms Issue Securities Primary New issue Key factor: issuer receives the proceeds from the sale Secondary Existing owner sells to another party Issuing firm doesn’t receive proceeds and is not directly involved

How Firms Issue Securities Continued: 

How Firms Issue Securities Continued Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)

Investment Banking : 

Investment Banking Underwritten: firm commitment on proceeds to the issuing firm Red herring Prospectus

Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public: 

Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

Shelf Registrations: 

Shelf Registrations SEC Rule 415 Introduced in 1982 Ready to be issued – on the shelf

Private Placements: 

Sale to a limited number of sophisticated investors not requiring the protection of registration Allowed under Rule 144A Dominated by institutions Very active market for debt securities Not active for stock offerings Private Placements

Initial Public Offerings: 

Initial Public Offerings Process Road shows Bookbuilding Underpricing Post sale returns Cost to the issuing firm

Figure 3.2 Average Initial Returns for IPOs in Various Countries: 

Figure 3.2 Average Initial Returns for IPOs in Various Countries

Figure 3.3 Long-term Relative Performance of Initial Public Offerings: 

Figure 3.3 Long-term Relative Performance of Initial Public Offerings

How Securities are Traded: 

How Securities are Traded Types of Markets Direct search Least organized Brokered Trading in a good is active Dealer Trading in a particular type of asset increases Auction Most integrated

Types of Orders: 

Types of Orders Market—executed immediately Bid Price Ask Price Price-contingent Investors specify prices Stop orders

Figure 3.4 The Limit Order Book for Intel on the Archipelago Market, January 19, 2007: 

Figure 3.4 The Limit Order Book for Intel on the Archipelago Market, January 19, 2007

Figure 3.5 Price-Contingent Orders: 

Figure 3.5 Price-Contingent Orders

Trading Mechanisms: 

Trading Mechanisms Dealer markets Electronic communication networks (ECNs) Specialists markets

U.S. Security Markets: 

U.S. Security Markets Nasdaq and NYSE have evolved in response to new information technology Both have increased their commitment to automated electronic trading

Nasdaq: 

Nasdaq National Market System Nasdaq Small Cap Market Levels of subscribers Level 1 – inside quotes Level 2 – receives all quotes but they can’t enter quotes Level 3 – dealers making markets

Table 3.1 Partial Requirements for Listing on NASDAQ Markets: 

Table 3.1 Partial Requirements for Listing on NASDAQ Markets

New York Stock Exchange: 

New York Stock Exchange Member functions Commission brokers Floor brokers Specialists Block houses SuperDot

Table 3.2 Some Initial Listing Requirements for the NYSE: 

Table 3.2 Some Initial Listing Requirements for the NYSE

Table 3.3 Block Transactions on the New York Stock Exchange: 

Table 3.3 Block Transactions on the New York Stock Exchange

Other Systems: 

Other Systems Electronic Communication Networks Private computer networks that directly link buyers with sellers National Market System Securities Act of Amendments of 1975 Bond Trading Automated Bond System (ABS)

Market Structure in Other Countries: 

Market Structure in Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges Tokyo Stock Exchange Globalization and consolidation of stock markets

Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007: 

Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007

Trading Costs: 

Trading Costs Commission : fee paid to broker for making the transaction Spread : cost of trading with dealer Bid : price dealer will buy from you Ask : price dealer will sell to you Spread : ask - bid Combination : on some trades both are paid

Buying on Margin: 

Buying on Margin Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

Stock Margin Trading: 

Stock Margin Trading Margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed Maintenance margin : minimum amount equity in trading can be before additional funds must be put into the account Margin call : notification from broker that you must put up additional funds

Margin Trading - Initial Conditions Example 3.1: 

Margin Trading - Initial Conditions Example 3.1 X Corp $100 60% Initial Margin 40% Maintenance Margin 100 Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

Margin Trading - Maintenance Margin Example 3.1: 

Margin Trading - Maintenance Margin Example 3.1 Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

Margin Trading - Margin Call Example 3.2: 

Margin Trading - Margin Call Example 3.2 How far can the stock price fall before a margin call? (100P - $4,000) * / 100P = 40% P = $66.66 * 100P - Amt Borrowed = Equity

Table 3.4 Illustration of Buying Stock on Margin: 

Table 3.4 Illustration of Buying Stock on Margin

Short Sales: 

Short Sales Purpose : to profit from a decline in the price of a stock or security Mechanics Borrow stock through a dealer Sell it and deposit proceeds and margin in an account Closing out the position: buy the stock and return to the party from which is was borrowed

Short Sale – Initial Conditions Example 3.3: 

Short Sale – Initial Conditions Example 3.3 Dot Bomb 1,000 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $100,000 Margin & Equity 50,000 Stock Owed 100,000

Short Sale - Maintenance Margin: 

Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $100,000 Initial Margin 50,000 Stock Owed 110,000 Net Equity 40,000 Margin % (40,000/110,000) 36%

Short Sale - Margin Call: 

Short Sale - Margin Call How much can the stock price rise before a margin call? ($150,000 * - 1000P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

Regulation of Securities Markets: 

Regulation of Securities Markets Major regulations Securities Act of 1933 Securities Act of 1934 Securities Investor Protection Act of 1970 Self-Regulation Stock markets are largely self-regulating

Regulation Securities Markets Continued: 

Regulation Securities Markets Continued Regulatory Responses to Recent Scandals Public Company Accounting Oversight Board Financial experts to serve on audit committees of boards of directors CEOs and CFOs personally certify firms’ financial reports Boards must have independent directors Sarbanes-Oxley Act

Circuit Breakers: 

Circuit Breakers Trading halts Collars

Insider Trading: 

Insider Trading Officers, directors, major stockholders must report all transactions in firm’s stock Insiders do exploit their knowledge Leakage of useful information to some traders